First American Financial Corp quarterly report, Q2 FY2012

First American Financial Corporation — Q2 2012 Form 10-Q

Business context and reporting period. Unaudited results cover the three and six months ended June 30, 2012, compared with the same periods in 2011. First American provides title insurance and related real estate services, specialty insurance, and trust and other services. Title and mortgage activity is seasonal and sensitive to real estate markets and interest rates. Unless indicated otherwise, amounts below are in millions.

Key financial results

Metric	Q2 2012	Q2 2011	H1 2012	H1 2011
Revenue	$1,089.8	$927.3	$2,056.6	$1,859.0
Income before taxes	$112.3	$49.2	$163.8	$25.8
Net income attributable to the Company	$73.0	$32.3	$104.3	$17.0
Diluted earnings per share	$0.68	$0.30	$0.97	$0.16
Cash dividends per share	$0.08	$0.06	$0.16	$0.12

• Revenue increased 17.5% in Q2 and 10.6% in H1. Pretax margin was approximately 10.3% in Q2 versus 5.3%; H1 margin was approximately 8.0% versus 1.4%.
• H1 operating cash flow was $104.3 million, versus cash used of $29.1 million in 2011. Claim payments, net of recoveries, were $227.2 million versus $233.2 million.
• Cash and cash equivalents rose to $796.2 million from $418.3 million at year-end. Total assets were $5.79 billion and total equity was $2.16 billion at June 30.
• Notes and contracts payable were $273.6 million, down from $300.0 million at year-end; this measure was 11.2% of total capitalization versus 12.8%. The company had $200 million drawn on its $600 million revolving facility and reported $400 million available; it was in covenant compliance.
• The effective tax rate was 34.5% for Q2 and 36.1% for H1. Management released a $5.3 million tax valuation allowance in Q1, benefiting tax expense and other comprehensive income.

Material changes and operating performance

• Management attributed the stronger results principally to improved mortgage activity. Direct title operations opened 411,200 orders in Q2, up 36.0%; closed 289,300, up 34.2%. U.S. mortgage originations by dollar value rose 28.3% year over year, driven by 52.8% growth in refinancings, while purchase originations declined 11.8%.
• Title Insurance and Services Q2 revenue grew 18.0% to $1.012 billion and pretax income rose to $118.4 million from $60.8 million; pretax margin improved to 11.7% from 7.1%. H1 pretax income was $179.3 million versus $45.1 million.
• Direct premiums and escrow fees rose 27.0% in Q2, while average revenue per closed direct order fell 5.4%, largely reflecting the greater mix of lower-premium refinance business. Agent premiums rose 14.9% in Q2; reported agent premiums generally lag policy issuance.
• Specialty Insurance Q2 revenue increased 11.1% to $79.6 million and pretax income increased 27.6% to $13.3 million; margin was 16.7% versus 14.5%. Higher home warranty claim frequency weighed on results; milder winter weather reduced property and casualty claims.
• Title claims provision was $54.8 million in Q2, or 6.6% of title premiums and escrow fees, versus $40.3 million and 5.9% in 2011. H1 provision declined to $107.0 million from $136.6 million, as 2011 included a $45.3 million reserve strengthening for a Canadian guaranteed valuation product.

Outlook, risks and unusual items

• No specific numerical earnings or revenue guidance was provided. Management said real estate and mortgage activity improved, expense control remained a focus, and it expected to continue quarterly dividends at or above the then-current level, subject to board discretion and other factors.
• Management believed resources were sufficient for operational requirements and obligations for at least 12 months. Holding-company liquidity included $94.2 million of cash, 6.0 million CoreLogic shares valued at $109.7 million, and $400 million of undrawn revolver capacity. Regulated subsidiaries had $210.2 million of potential dividends, loans and advances available in 2012.
• On July 24, 2012, after quarter-end, the company sold 4.0 million CoreLogic shares for $90.3 million. It expected to recognize a $15.2 million gain in Q3 2012. The company held 8.9 million shares at June 30 and had agreed to dispose of them within five years of the 2010 separation or bear potential adverse tax consequences.
• Title claims reserves totaled $974.0 million, including $801.2 million of incurred-but-not-reported claims. Management cautioned that a 50-basis-point change in expected loss rates for the six most recent policy years could change the IBNR reserve by approximately $115.5 million. The Canadian guaranteed valuation product had $4.6 million of H1 net unfavorable development and unusually high uncertainty in ultimate claims.
• The investment portfolio included $28.3 million fair value of non-agency mortgage-backed securities, all rated below investment grade or unrated; further impairment losses remain possible. The filing also identifies interest-rate, market, credit, real-estate, regulatory, data-security, customer concentration, agent conduct, pension funding and subsidiary-dividend risks.
• The company disclosed numerous pending lawsuits, many involving title rates, referral practices, competition and consumer claims, plus regulatory audits and investigations. For many matters it could not estimate the probability or range of loss. It did not expect the identified audits or investigations to have a material adverse effect individually or in aggregate, but said resulting business-practice changes could be material.
• Other notable items: investment income declined as yields remained low; H1 net realized investment gains were $7.1 million versus losses of $2.5 million in 2011. The company contributed $17.4 million to pension plans in H1 and expected to contribute another $16.8 million during the rest of 2012.

Important facts for investors to verify

1. Whether elevated refinance volumes and title order growth persist, given the decline in purchase originations and the sensitivity of revenue to interest rates and housing activity.
2. Future claims development, especially the Canadian guaranteed valuation product, and whether reserve assumptions remain adequate against the disclosed $115.5 million sensitivity.
3. The Q3 accounting and use of proceeds from the CoreLogic share sale, along with remaining concentration and tax implications.
4. Developments in litigation, regulatory inquiries, title-rate oversight and any resulting changes to business practices or costs.
5. Cash availability and debt terms, including regulated limits on subsidiary distributions, revolver covenants and the company’s ability to sustain dividends.